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Exchange Rates and
The Open Economy
Principles of Macroeconomics
Dr. Gabriel X. Martinez
Ave Maria University
Introduction
 Have you visited any foreign countries?
 What currency did they use there?
 What was the exchange rate of that
currency with the dollar?
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Chapter 29: Exchange Rates and
the Open Economy
2
Exchange Rates
 To make a transaction with a foreign
country, first you need to get that country’s
currency.
€
Pierre wants American
pickles. He has €30.
Copyright c 2004 by The McGraw-Hill
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$
Pierre takes his
€30 to the
foreign
exchange
market and gets
$36.
Chapter 29: Exchange Rates and
the Open Economy
Pickle Co., in the US,
sends him $36 worth
of pickles.
3
Exchange Rate Policy
 The choice of an exchange rate policy is
tremendously important.
 A flexible exchange rate
– allows fluctuations in the value of a currency. It
generates some uncertainty but it leaves
monetary policy free to pursue national
objectives.
 A fixed exchange rate
– generates more certainty, but it ties monetary
policy to this single overriding goal, and it is
open to speculative attacks.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
4
Sources of Information
 Exchange rates from the real world are available at a number of on-line
sites.
 The St. Louis Federal Reserve
(http://research.stlouisfed.org/fred2/categories/13) offers tables as well
as graphs for a limited number of countries. The graphs show the
number of units of foreign currency that can be purchased for one US
dollar for a five (or more) year period.
 The New York Federal Reserve provides daily reports of current rates
for many countries. The exchange rate is reported as units of foreign
currency per US dollar. Go to (http://www.ny.frb.org) link to “markets”
and then to “Foreign Exchange.”
 You will also find an “Exchange Rate Calculator” or “Currency
Converter” at http://www.oandnda.com/convert/classic. This converter
has a database that includes 164 currencies and can provide historical
data (back as far as three decades in some cases) in tabular or graphic
form.
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Chapter 29: Exchange Rates and
the Open Economy
5
Imagine
 Imagine a business trip to Montreal, Canada. The
trip is to be made May 10-14, 2006 and the
meetings are to be held in the Hilton Montreal
Bonaventure Hotel – one of the premium hotels
near the city center.
 Like most major hotels in Canadian cities, the
Montreal Bonaventure will accept either Canadian
currency ($CAN) or U.S. currency ($US).
 The following nightly rates have been given to you:
$225.00CAN per night
$171.40US per night
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Chapter 29: Exchange Rates and
the Open Economy
6
Imagine
 The exchange rate at the time of the trip is
quoted as 1.3876 indicating that $1US will
exchange for $1.3876 CAN.
 Should you pay using Canadian or U.S.
currency?
 If you choose U.S. currency, you will pay the
$171.40, but if you exchange the $171.40
for Canadian currency, you will receive
$1.3876 CAN for each U.S. dollar for a total
of
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Chapter 29: Exchange Rates and
the Open Economy
7
Imagine
 $171.40 US X $1.3876CAN/1$US = $237.83 CAN
 After exchanging the currency, you can pay in US
dollars and pay the equivalent of $237.83 CAN.
 Or you can pay the hotel its $225CAN per night
and keep the $12.83CAN + as a surplus that you
earned as a result of being aware of exchange
rates.
 This kind of calculation and transaction is very
familiar and almost continuous among travelers
who cross from one country (currency) to another.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
8
Imagine Again
 You are a business person. Your firm is an
importer-exporter.
 You buy de Beers diamonds from South
Africa, French wines, Japanese
automobiles, Indian cashews, and sell
American DVDs and computer software.
 If you don’t know everything about
exchange rates, you’ll go broke in two
months.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
9
Exchange Rates: Definitions
Exchange Rates
 Nominal Exchange Rate
– The rate at which two currencies can be traded
for each other
$
€
$
€
€1
€
€
$
$
$
€
€
€0.5
$
$
$
$
€
€
$
$
$
$
$
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Chapter 29: Exchange Rates and
the Open Economy
11
Exchange Rates
 Nominal Exchange Rate
– The rate at which two currencies can be traded
for each other
$
€
$
€
$1
€
€
€
$
$
€
€
$2
$
$
$
$
€
€
€
$
$
$
$
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
12
Exchange Rates
 Nominal Exchange Rates
– The exchange rate between British and
Canadian currencies
 0.6393 British pounds = $1 U.S.
 1.5674 Canadian $s = $1 U.S.
 0.6393 British pounds = 1.5674 Canadian $s
 0.6393/1.5674 = 0.4079 pounds = 1 Canadian $
 British/Canadian exchange 0.4079 pounds per
Canadian dollar
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Chapter 29: Exchange Rates and
the Open Economy
13
Nominal Exchange Rates
for the U.S. Dollar
Country
Foreign currency/dollar
Dollar/foreign currency
United Kingdom (pound)
0.581
1.7221
Canada (Canadian dollar)
1.1656
0.8579
Mexico (peso)
10.5715
0.09459
Japan (yen)
119.25
0.00839
Switzerland (Swiss franc)
1.311
0.76278
South Korea (won)
1039.4
0.000962
Euro
0.8431
1.18603
Nov 28, 2005
The dollar has weakened since 2002 (except against the peso)
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Chapter 29: Exchange Rates and
the Open Economy
14
Imagine Again
 You are a business person. Your firm is an
importer-exporter.
– You buy de Beers diamonds from South Africa,
French wines, Japanese automobiles, Indian
cashews, and sell American DVDs and
computer software.
 Every time you carry out one of these
transactions, you must exchange one
currency for another, at the nominal
exchange rate.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
15
The U.S. Nominal
Exchange Rate, 1973-2002
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Chapter 29: Exchange Rates and
the Open Economy
16
Exchange Rates
 Appreciation
– An increase in the value of a currency
relative to other currencies
 Depreciation
– A decrease in the value of a currency
relative to other currencies
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Chapter 29: Exchange Rates and
the Open Economy
17
Visiting Austria
 Suppose you are going to Austria next
semester.
 You’ve saved up $2,000 for traveling. At an
exchange rate of $1.18/€, that means
€1,695.
– That’s about 90 meals.
 But then, alas! The Euro appreciates to
$1.92/€. Now you only have €1,041.
– That’s about 54 meals.
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Chapter 29: Exchange Rates and
the Open Economy
18
Exchange Rates
 Some Definitions
e = the number of units
of foreign currency that
1 unit of domestic
currency will buy
– e = nominal exchange rate
– e = the number of units of foreign currency
that the domestic currency will buy
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Chapter 29: Exchange Rates and
the Open Economy
19
Exchange Rates
 When e increases, the domestic
currency appreciates
 When e decreases, the domestic
currency depreciates
e = the number of units
of foreign currency that
1 unit of domestic
currency will buy
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
20
Imagine Again
 You are a business person. Your firm is an
importer-exporter.
– You buy de Beers diamonds from South Africa,
French wines, Japanese automobiles, Indian
cashews, and sell American DVDs and
computer software.
 If the Dollar appreciates, US goods become
more expensive and harder to sell to foreign
lands; foreign goods become cheaper and
more attractive.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
21
Exchange Rates
 Flexible Exchange Rate
– An exchange rate whose value is not
officially fixed but varies according to the
supply and demand for the currency in
the foreign exchange market.
 Foreign Exchange Market
– The market on which currencies of various
nations are traded for one another
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Chapter 29: Exchange Rates and
the Open Economy
23
Exchange Rates
 Fixed Exchange Rate
– An exchange rate whose value is set by
official government policy
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Chapter 29: Exchange Rates and
the Open Economy
24
Exchange Rates
 The Real Exchange Rate
– Nominal exchange rate
 The number of units of foreign currency that the
domestic currency will buy
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Chapter 29: Exchange Rates and
the Open Economy
25
Exchange Rates
 The Real Exchange Rate
– Real exchange rate
 The number of units of foreign GDP that 1 unit of
domestic GDP can buy.
 The price of the average domestic good or
service relative to the price of the average
foreign good or service, when the prices are
expressed in terms of a common currency.
 How many loaves of French bread are needed
to buy an American loaf of sliced bread?
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Chapter 29: Exchange Rates and
the Open Economy
26
Exchange Rates
 The Real Exchange Rate
– Real exchange rate
 While knowing the magnitude of the real
exchange rate is likely of little interest to an
individual traveler making a one-week trip to
Iceland,
it is important and useful to importers and
exporters who need information regarding the
general relationship between two currencies and
two economies.
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Chapter 29: Exchange Rates and
the Open Economy
27
Imagine Again
 You are a business person. Your firm is an
importer-exporter.
– You buy de Beers diamonds from South Africa,
French wines, Japanese automobiles, Indian
cashews, and sell American DVDs and
computer software.
 What you are really interested in, ultimately,
is how many DVDs you have to sell to get
so many bottles of wine.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
28
Exchange Rates
 Example
– You are the Director of Purchases for
Consumer Services, Inc.
– You are considering whether to buy
1,000,000 computers. Should you buy
Japanese or American computers?
 Price in yen
= price in dollars x (yen-dollar exchange rate)
 Price in dollars
= price in yen / (yen-dollar exchange rate)
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e =Chapter
the number
of units of foreign currency that 1 unit of
29: Exchange Rates and
domesticthecurrency
will buy
Open Economy
29
Price in the
original
country
US
computer
Japanese
Computer
Currency
Price in the
Conversion other
country
$2,400
$2,400 *
110 yen/dollar
¥264,000
¥242,000
¥242,000 /
110 yen/dollar
$2,200
Chapter
Exchange
e = 110 yen/dollar
= the29:number
ofRates
unitsand
of foreign
Copyright c 2004 by The McGraw-Hill
the Open Economy
that 1 unit of domestic currency will buy
Companies, Inc. All rightscurrency
reserved.
30
Exchange Rates
 Example
– Should you buy Japanese or American
computers for your company?
e = the number of units
 Japanese computers are cheaper.
of foreign currency that
1 unit of domestic
currency will buy
 Price of U.S. computer = $2,400
 Price in of Japanese computer in dollars =
242,000 yen/110 = $2,200
 Real exchange rate = $2,400/$2,200 = 1.09
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Chapter 29: Exchange Rates and
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31
Exchange Rates
 Real Exchange Rate
Real Exchange Rate 
Price of domestic good (P )
Price of foreign good, in dollars (P f )
Real Exchange Rate 
P
P f /e
eP
RER  f
P
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Chapter 29: Exchange Rates and
the Open Economy
32
Exchange Rates
 The Computer Example, revisited
– E = 110/$1
– P = $2,400
– Pf = 242,000 yen
e = the number of units
of foreign currency that
1 unit of domestic
currency will buy
(110 yen/$1) x $2,400
Real Exchange Rate 
242,000 yen
264,000 yen
Real Exchange Rate 
 1.09
242,000 yen
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Chapter 29: Exchange Rates and
the Open Economy
33
Exchange Rates
 The Real Exchange Rate
– A high real exchange rate makes it difficult for
domestic producers to export to other countries:
domestic goods are too expensive.
– A high (appreciated) real exchange rate attracts
imports.
This is an important topic of
International Monetary Economics, ECO 421
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Chapter 29: Exchange Rates and
the Open Economy
e = the number of units
of foreign currency that
1 unit of domestic
currency will buy
34
Austria, Revisited
 You’d saved up $2,000. If e = $1.18/€, that
means €1,695, about 90 meals.
 But the dollar depreciates to $1.92/€, you
only have €1,041, about 54 meals.
 The dollar depreciation made the Euro
appreciate.
 This made European meals more expensive
and less attractive.
Copyright c 2004 by The McGraw-Hill
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Chapter 29: Exchange Rates and
the Open Economy
35
Exchange Rates
 The Real Exchange Rate
– NX will tend to be low when the real exchange
rate is high.
– Real and nominal exchange rates tend to
move in the same direction
e = the number of units
of foreign currency that
1 unit of domestic
currency will buy
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Chapter 29: Exchange Rates and
the Open Economy
36
Exchange Rates
 Economic Naturalist
– Does a strong currency imply a strong
economy?
 A currency will get strong if there is a high
demand for the country’s goods (and therefore
its currency).
 But if an economy has a big trade deficit
(Imports > Exports), a devaluation of the
currency will solve the problem: it makes
domestic goods more competitive.
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Chapter 29: Exchange Rates and
the Open Economy
37
Real Exchange Rates,
US/CAN, US/MEX
16
1.8
14
1.6
12
1.4
1.2
10
1
8
0.8
6
0.6
4
0.4
2
0.2
0
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Mexico
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Canada
Chapter 29: Exchange Rates and
the Open Economy
38
Determination of Exchange
Rates
Purchasing Power Parity
This is an important topic of
International Monetary Economics, ECO 421
The Determination of the Exchange
Rate
 A blank DVD is a blank DVD, right? So it
should cost the same everywhere.
 Law of One Price
– If transportation costs are relatively small, the
price of an internationally traded commodity
must be the same in all locations.
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Chapter 29: Exchange Rates and
the Open Economy
40
Imagine Again
 Your firm is an importer-exporter.
 Suppose you could get the exact same
diamond from South Africa and also from
Australia.
 After taking into account the nominal
exchange rate, either
1. prices are exactly the same, so you’re
indifferent or
2. prices are different, and you’d buy from the
cheapest until prices came to equality.
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Chapter 29: Exchange Rates and
the Open Economy
41
The Determination of the Exchange
Rate
 Purchasing Power Parity (PPP)
– “Nominal exchange rates move so that the law
of one price can hold.”
=
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Chapter 29: Exchange Rates and
the Open Economy
42
The Determination of the Exchange
Rate
 Purchasing Power Parity (PPP)
The Real Exchange rate = e P / Pf
PPP implies Pe = Pf and
e=Pf/P
 This way, if I have domestic blank DVD, I
can sell it, get home currency, change it into
foreign currency, and a foreign blank DVD.
PPP implies
e=Pf/P
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It also implies
De=DPf – DP
:
Chapter 29: Exchange Rates and
the Open Economy
Currency depreciates
if DP > DPf
43
The Determination of the Exchange
Rate
 Purchasing Power Parity (PPP)
– In the long run, the currencies of countries that
experience significant inflation will tend to
depreciate.
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Chapter 29: Exchange Rates and
the Open Economy
44
The Determination of the Exchange
Rate
 Example
– How many Indian rupees equal to one
Australian dollar?
 A Bushel of grain is the same bushel of grain in India
or in Australia.
 A bushel of grain costs 5 Australian dollars or 150
rupees
 5 Australian dollars = 150 rupees
 Nominal exchange should equal 30
rupees/Australian dollar
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Chapter 29: Exchange Rates and
the Open Economy
45
The Determination of the Exchange
Rate
 Example
– How many Indian rupees equal one Australian
dollar?
 Suppose the Price of grain in India increases from
150 to 300 rupees
 But Price of Indian grain in Australia stays equal to 5
Australian dollars
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Chapter 29: Exchange Rates and
the Open Economy
46
The Determination of the Exchange
Rate
 Example
– Now, how many Indian rupees equal one
Australian dollar?
 5 Australian dollars = 300 rupees
 1 Australian dollar = 60 rupees
 Nominal exchange rate increased from 30 to 60
rupees/Australian dollar
 Indian currency depreciated
 Australian currency appreciated
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Chapter 29: Exchange Rates and
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47
The Determination of the Exchange
Rate
 Example
– Shortcomings of the PPP Theory
 The theory has
been successful
in the long run
but not the
short run.
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Chapter 29: Exchange Rates and
the Open Economy
48
The Determination of the Exchange
Rate
 Example
– Limits to the PPP Theory
 Not all goods and services are traded internationally.
– The greater the share of non-traded goods, the less precise
the PPP theory
 Not all internationally traded goods and services are
perfectly standardized commodities.
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Chapter 29: Exchange Rates and
the Open Economy
49
The Big Mac Index
 The Economist's Big Mac index seeks to
make exchange-rate theory more digestible.
 It is arguably the world's most accurate
financial indicator to be based on a fast-food
item.
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Chapter 29: Exchange Rates and
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50
The Big Mac Index
 The Big Mac index, which The Economist
has compiled since 1986, is based on the
notion that a currency's price should reflect
its purchasing power.
 In other words, a unit of currency should buy
the same amount of burger anywhere.
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Chapter 29: Exchange Rates and
the Open Economy
51
The Big Mac Index
 Their index shows that burger prices can
certainly fall out of line with each other.
 If he could keep the burgers fresh, an
ingenious arbitrageur could buy Big Macs
for the equivalent of $1.27 in China, whose
yuan is the most undervalued currency in
our table, and sell them for $5.05 in
Switzerland, whose franc is the most
overvalued currency.
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Chapter 29: Exchange Rates and
the Open Economy
53
The Big Mac Index
 The impracticality of such a trade highlights
some of the flaws in the PPP idea. Trade
barriers, transport costs and differences in
taxes drive a wedge between prices in
different countries.
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Chapter 29: Exchange Rates and
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54
The Big Mac Index
 More important, the $5.05 charged for a
Swiss Big Mac helps to pay for the retail
space in which it is served, and for the labor
that serves it. Neither of these two crucial
ingredients can be easily traded across
borders.
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Chapter 29: Exchange Rates and
the Open Economy
55
The Big Mac Index
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Chapter 29: Exchange Rates and
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56
The Big Mac Index
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Chapter 29: Exchange Rates and
the Open Economy
57
Determination of Exchange
Rates
Supply and Demand Analysis
Imagine Again
 You are a business person. Your firm is an
importer-exporter.
 Every time you buy some Indian cashews,
you must buy Indian rupees (their currency),
that is, demand rupees.
 Every time you sell some American DVDs to
an Indian firm, it must sell rupees to buy
dollars, that is, supply rupees.
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Chapter 29: Exchange Rates and
the Open Economy
59
Supplying A Currency
 A recent newspaper account indicates that WalMart sells approximately 10 percent of all Chinesemade items sold in the United States economy.
 Since Wal-Mart does not earn large amounts of
yuan in China, the retail giant must go to the
currency market to get the yuan with which to buy
Chinese goods.
 Wal-Mart must selling a lot of dollars to buy the
Chinese currency.
 Wal-Mart is a supplier of dollars.
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Chapter 29: Exchange Rates and
the Open Economy
60
Demanding A Currency
 The People’s Bank of China buys billions of
dollars worth of U.S. assets (government
securities) and in that way it finances a large
part of the US current account deficit.
 Since the PBoC does not print dollars, it
must buy them in the market for currency.
 The bank then becomes a demander of
dollars.
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Chapter 29: Exchange Rates and
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61
Demand and Supply for Currency
 The Demand for Dollars in the Forex Market
– Happens in the foreign exchange market
– Someone wants to get rid of some currency to
buy dollars.
– Is distinct from “money demand”, which is the
allocation of wealth.
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Chapter 29: Exchange Rates and
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62
Demand and Supply for Currency
 The Supply of Dollars in the Forex Market
– Happens in the foreign exchange market
– Someone wants to buy another currency with
some dollars, and so sells the dollars.
– Is distinct from “money supply”, set by the CB.
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Chapter 29: Exchange Rates and
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63
The Supply and Demand for
Dollars In The Yen-Dollar Market
Yen/dollar exchange rate
The equilibrium exchange rate
(e*) or fundamental exchange rate
makes the quantities of dollars
supplied and demanded equal
Supply of dollars
e*
Demand for dollars
Quantity of dollars traded
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Chapter 29: Exchange Rates and
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64
The Determination of the Exchange
Rate
 Changes in the Supply of Dollars
– Factors that increase the supply of dollars
 An increase in the preference for Japanese goods
 An increase in U.S. real GDP
 An increase in the real interest rate on Japanese
assets
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Chapter 29: Exchange Rates and
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65
The Determination of the Exchange
Rate
 Changes in the Supply of Dollars
– Factors that increase the supply of dollars
 An increase in the preference for Japanese goods
 An increase in U.S. real GDP
 An increase in the real interest rate on Japanese
assets
$
¥
A Toyota
goes to US
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Chapter 29: Exchange Rates and
the Open Economy
66
An Increase In The Supply of
Dollars Lowers The Value of The Dollar
Yen/dollar exchange rate
•Increase in demand for Japanese video games
•Supply of dollars increases from S to S’
•The value of the dollar in terms of yen falls
•e* falls to e*’
S
S’
E
e*
e*’
F
D
Quantity of dollars traded
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Chapter 29: Exchange Rates and
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67
The Determination of the Exchange
Rate
 Changes in the Demand for Dollars
– Factors that increase the demand for dollars
 Increased preference for U.S. goods
 Increase in real GDP abroad
 An increase in the real interest rate on U.S. assets
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Chapter 29: Exchange Rates and
the Open Economy
68
The Determination of the Exchange
Rate
 Changes in the Demand for Dollars
– Factors that increase the demand for dollars
 Increased preference for U.S. goods
 Increase in real GDP abroad
 An increase in the real interest rate on U.S. assets
¥
$
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Chapter 29: Exchange Rates and
the Open Economy
The Bank of
Japan buys a
US bond
69
Yen/dollar exchange rate
A Tightening of Monetary
Policy Strengthens the Dollar
• Tighter monetary policy raises the
domestic real interest rate
• Foreign demand for U.S. assets
increase
S
e*’
E
F
• The demand for dollars rises
• Exchange rate appreciates from
e* to e*’
e*
D’
D
Quantity of dollars traded
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Chapter 29: Exchange Rates and
the Open Economy
70
Demand and Supply of Currency
 The equilibrium exchange rate (e*) or
fundamental exchange rate makes the
quantities of dollars supplied and demanded
equal.
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Chapter 29: Exchange Rates and
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71
Monetary Policy and
the Exchange Rate
 Economic Naturalist
– Why do people think the dollar will
depreciate brutally in the next few months?
 Right now, there’s a tremendous demand for US
dollars by foreigners to pay for the $700 billion
current account annual deficit.
 If they chose not to buy dollars, the demand for
the dollar (and its foreign-exchange value) would
collapse.
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Chapter 29: Exchange Rates and
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72
Monetary Policy and
the Exchange Rate
This is an important topic of
International Monetary Economics, ECO 421
Monetary Policy and
the Exchange Rate
 The Exchange Rate as a Tool of
Monetary Policy
– When the exchange rate is flexible:
 Tighter monetary policy reduces net exports.
– By raising the interest rate, the exchange rate
appreciates.
 Easier monetary policy stimulates net exports.
– By lowering the interest rate, the exchange rate
depreciates.
 Monetary policy is more effective in an open
economy with flexible exchange rates.
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Chapter 29: Exchange Rates and
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74
Monetary Policy and
the Exchange Rate
 The Exchange Rate is a Tool of Monetary
Policy
– When the exchange rate is flexible:
 Tighter monetary policy reduces net exports.
– A higher interest rate makes purchasing domestic
assets (such as bonds) bonds more attractive.
– As people buy domestic assets, the exchange rate
appreciates.
– As e appreciates, imports become cheaper.
– As e appreciates, exports become more expensive.
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Chapter 29: Exchange Rates and
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M↓
i↑
e↑
NX ↓
Y↓
75
Monetary Policy and
the Exchange Rate
 The Exchange Rate is a Tool of Monetary Policy
 Tighter monetary policy reduces net exports.
–
–
–
–
–
As e appreciates, imports become cheaper.
As e appreciates, exports become more expensive.
Ex: suppose e = €1/$.
French wine costs €30. Notice €30 / €1/$ = $30.
Californian wine costs $30. Notice $30 x €1/$ = €30.
– Suppose e = €2/$, so the dollar is worth more euros.
– French wine costs €30. Now €30 / €2/$ = $15.
– Californian wine costs $30. Now $30 x €2/$ = €60.
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Chapter 29: Exchange Rates and
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76
Monetary Policy and
the Exchange Rate
 The Exchange Rate as a Tool of Monetary
Policy
 Easier monetary policy stimulates net exports.
– By lowering the interest rate, the exchange rate
depreciates.
– As e depreciates, imports become more expensive.
– As e depreciates, exports become cheaper.
– Suppose e = €0.5/$, so the dollar is worth fewer
euros.
– French wine costs €30. Now €30 / €0.5/$ = $60.
– Californian wine costs $30. Now $30 x €0.5/$ = €15.
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Chapter 29: Exchange Rates and
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M↑
i↓
e↓
NX ↑
Y↑
77
Imagine Again
 You are a business person. Your firm is an
importer-exporter.
 If the Fed lowers interest rates, the dollar
will be pressured downward.
 Your import business will suffer (foreign
goods will become more expensive) but
your export business will benefit (US goods
will become cheaper).
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Chapter 29: Exchange Rates and
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78
Fixed Exchange Rates
This is an important topic of
International Monetary Economics, ECO 421
Fixed Exchange Rates
 Suppose you are an importer-exporter.
– You buy de Beers diamonds from South Africa,
French wines, Japanese automobiles, Indian
cashews, and sell American DVDs and
computer software.
 Wouldn’t you like to know that the value of
the US Dollar will stay constant relative to
these currencies for the foreseeable future?
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Chapter 29: Exchange Rates and
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80
Fixed Exchange Rates
 For many, many years, the US fixed the
value of the dollar to Gold
– Right now, many countries still fix the value of
their currencies to the dollar or other currencies
 (they “peg” their currency to the dollar, Euro, etc.).
– Countries believe that fixing the exchange rate
generates more stability and predictability.
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Chapter 29: Exchange Rates and
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81
Fixed Exchange Rates
 Fixed Exchange Rates
– The government will peg its currency to a major
currency
 or to a “basket” of currencies.
– The Central Bank declares that it will buy and
sell unlimited amounts of domestic currency at
that particular price.
– For example, the Thai baht may be pegged to
the US dollar.
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Chapter 29: Exchange Rates and
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82
Fixed Exchange Rates
 Fixed Exchange Rates
– Suppose the exchange rate is fixed, but some
event requires a change in the parity
 (parity: the number, the precise value of e at which
the exchange rate is fixed)
– The government may have to devalue or
revalue its currency.
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Chapter 29: Exchange Rates and
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83
Fixed Exchange Rates
 Devaluation
– A reduction in the official value of a currency (in
a fixed-exchange-rate system)
 Revaluation
– An increase in the official value of a currency (in
a fixed-exchange-rate system)
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Chapter 29: Exchange Rates and
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84
Fixed Exchange Rates
 Overvalued Exchange Rate
– An exchange rate that has an officially fixed
value greater than its fundamental value
 Undervalued Exchange Rate
– An exchange rate that has an officially fixed
value less than its fundamental value
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Chapter 29: Exchange Rates and
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85
An Overvalued Exchange
Rate
Dollar/peso exchange rate
• The peso’s official value is greater than the
fundamental value; the peso is overvalued
• To maintain the value, the government must
purchase a quantity of pesos (A-B)
Supply of pesos
0.125 dollar/
peso
A
B
Official value
Fundamental value
0.10 dollar/
peso
Demand for pesos
Quantity of pesos traded
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Chapter 29: Exchange Rates and
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86
Imagine Again
 You are an importer.
– If the dollar is overvalued vis-à-vis the Euro, you
will lobby the Treasury to keep it overvalued,
because your dollars will buy more European
goods.
 You are an exporter (or you compete with
imports).
– If the dollar is overvalued vis-à-vis the Chinese
yuan, you will pressure the Treasury to make
the Chinese revalue their currency, which will
make Chinese goods more expensive and
yours relatively cheaper.
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Chapter 29: Exchange Rates and
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87
Fixed Exchange Rates
How to Fix an Exchange Rate
How to Fix an Exchange Rate
 Suppose you’ve fixed your exchange rate at
0.125 dollar/peso = 8 pesos/dollar.
 But the fundamental value is 0.1 dollar/peso
= 10 pesos/dollar
– This is the value at which quantity demanded
and quantity supplied are equal.
 The Dollar is undervalued
 The peso is overvalued.
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Chapter 29: Exchange Rates and
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89
How to Fix an Exchange Rate
 Suppose the peg was at 0.08 dollar/peso
(= 12.5 pesos/dollar).
 because the fundamental value is 0.1
dollar/peso = 10 pesos/dollar.
– This is the value at which quantity demanded
and quantity supplied are equal.
 The Dollar is overvalued (it should be worth
less).
 The peso is undervalued.
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Chapter 29: Exchange Rates and
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90
How to Fix an Exchange Rate
 Responses to an overvalued currency
– Devalue the currency: adjust the official
value of the currency to equal the
fundamental value.
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91
How to Fix an Exchange Rate
 Responses to an overvalued currency
– Impose trade barriers: prevent people
from trading, either goods and services, or
the currency (this last is called capital
controls).
 This reduces the supply of currency and
ameliorates the excess supply. Hence, the
price of currency (the exch. rate) doesn’t get
pushed in any way.
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How to Fix an Exchange Rate
 Responses to an overvalued currency
– The Central Bank can buy large amounts
of the currency : increase the demand for
domestic currency so the fundamental
value rises to equal the official value.
 To purchase your own currency (to keep its
value high) you must sell other country’s
currencies, that is, your international
reserves.
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Chapter 29: Exchange Rates and
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How to Fix an Exchange Rate
 International Reserves
– Foreign currency assets held by a government
for the purpose of purchasing the domestic
currency in the foreign exchange market.
– To purchase its own currency, a country must
hold international reserves.
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Chapter 29: Exchange Rates and
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94
How to Fix an Exchange Rate
 An overvalued currency leads to a balance
of payments deficit
– Leads to a net decline in international reserves
over a year if exchange rates are fixed.
– IM = 500 and X = 400.
 NX = – 100.
– Suppose it has KI = 80. Where does it get the
extra 20 to pay for the extra imports?
 NX + KI = – 100 + 80 = – 20 = BOP < 0.
 This 20 is called a BOP deficit
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Chapter 29: Exchange Rates and
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How to Fix an Exchange Rate
 An overvalued currency leads to a balance
of payments deficit
– If exchange rates are flexible, e depreciates:
imports fall and exports rise. This makes
BOP=0.
– If exchange rates are fixed and BOP<0, the
currency is overvalued and the CB sells
international reserves to defend the exchange
rate.
 The currency is overvalued because if it were
allowed to lose value, X would become more
competitive and rise, increasing NX and BOP.
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Chapter 29: Exchange Rates and
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How to Fix an Exchange Rate
 An undervalued currency leads to a balance
of payments surplus
– When a balance-of-payments surplus occurs, a
country has a net increase in international
reserves over a year.
 Suppose X – IM = 100 and capital outflows = -50.
 NX + KI = 100 – 50 = 50 = BOP > 0.
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Chapter 29: Exchange Rates and
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97
How to Fix an Exchange Rate
 Example
– Latinia’s balance-of-payments deficit
 Official value of the peso = 0.125 dollars
 Demand = 25,000 - 50,000e
 Supply = 17,600 + 24,000e
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Chapter 29: Exchange Rates and
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98
How to Fix an Exchange Rate
 Example
– Latinia’s balance-of-payments deficit
 Official value of the peso = 0.125 dollars
 Demand = 25,000 - 50,000e
 Supply = 17,600 + 24,000e
 Fundamental value
– 25,000 - 50,000e = 17,600 + 24,000e
 Solving for e:
– 7,400 = 74,000e
– e = 0.10
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Chapter 29: Exchange Rates and
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How to Fix an Exchange Rate
 Example
– At the official rate -- 0.125, the demand for
currency is…
– D = 25,000 - 50,000(0.125) = 18,750
– And the supply of currency is …
– S = 17,600 - 24,000 (0.125) = 20,600
– Excess supply = 1,850 pesos
– Balance of payments deficit = 1,850 pesos
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Chapter 29: Exchange Rates and
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100
How to Fix an Exchange Rate
 Latinia is running a P 1,850 BOP deficit
because there’s an excess supply of pesos.
– People are getting rid of pesos to buy imports
and foreigners are not buying enough pesos
back to buy exports.
 The explanation for the excess supply is that
the currency is overvalued: the fixed e is too
high compared to the equilibrium value.
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Chapter 29: Exchange Rates and
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101
How to Fix an Exchange Rate
 Latinia has an overvalued currency which
generates an excess supply of pesos.
 Its Central Bank will have to increase the
demand for pesos until QD = QS.
 It will buy pesos and sell dollars.
 Buying pesos will reduce the money supply
and raise interest rates.
– Selling dollars will reduce the bank’s
international reserves.
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Chapter 29: Exchange Rates and
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102
Fixed Exchange Rates
Speculative Attacks
Fixed Exchange Rates
 Suppose a currency is overvalued
– That is, the fundamental value is below the
official value.
– There’s an excess supply of pesos, so the CB
buys up the pesos (demand) by selling dollars
(i.e., international reserves).
– In other words, the CB defends the exchange
rate peg by selling international reserves, but
financial investors know that the CB doesn’t
have an infinite amount of int’l reserves.
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Fixed Exchange Rates
 Suppose a currency is overvalued
– That is, the fundamental value is below the
official value.
– The CB defends the exchange rate peg by
selling international reserves, but financial
investors know that int’l reserves will run out.
 Speculative Attack
– A massive selling of domestic currency assets
by financial investors
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Chapter 29: Exchange Rates and
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105
A Speculative Attack
on the Peso
• Peso overvalued at 0.125
• Central bank buys pesos
• Investors launch a speculative attack -- sell
peso dominated assets
Dollar/peso exchange rate
S
S’
0.125 dollar/
peso
A
B
C
Official value
• Supply of pesos increases
• Central bank must purchase
more pesos
0.10 dollar/
peso
D
Quantity of pesos traded
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Chapter 29: Exchange Rates and
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106
Fixed Exchange Rates
 Speculative Attack
– It generates a large excess supply of currency
at the fixed exchange rate.
– This excess supply has to be covered by selling
international reserves.
– If the excess supply is large enough, and is
maintained for long enough, the country runs
out of international reserves and has to
abandon the peg!
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Chapter 29: Exchange Rates and
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107
Fixed Exchange Rates
 Economic Naturalist
– Can a speculative attack occur under flexible
exchange rates?
 Not in the sense of investors forcing the CB to sell all
of its reserves, because, by definition, the CB is not
selling any reserves.
 Yes, in the sense that they can come to believe that
the exchange rate will depreciate in the near future,
and so they sell massive amounts of the currency,
shifting the Supply curve to the right.
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Chapter 29: Exchange Rates and
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108
Fixed Exchange Rates
 What is the alternative to selling reserves
(and risking a speculative attack)?
 To defend an exchange rate peg,
– Impose capital controls or tariffs
– Change monetary policy
 To defend an overvalued currency, tighten and raise
interest rates.
 To defend an undervalued currency, loosen and
lower interest rates.
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109
A Tightening of Monetary
Policy Eliminates An Overvaluation
•Pesos overvalued at 0.125
•Tightening monetary policy increases D to D’
•Official value = fundamental value
Dollar/peso exchange rate
S
F
0.125 dollar/
peso
Official value
E
0.10 dollar/
peso
D’
D
Quantity
of pesos traded
Chapter 29: Exchange Rates and
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the Open Economy
110
Fixed Exchange Rates
 If monetary policy is used to set the
fundamental value of the exchange rate
equal to the official value, it is no longer
available for stabilizing the domestic
economy.
– The Central Bank loses control of monetary
policy when it pegs the exchange rate.
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Chapter 29: Exchange Rates and
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111
Fixed Exchange Rates
 The conflict monetary policymakers face,
between stabilizing the exchange rate and
stabilizing the domestic economy, is most
severe when the exchange rate is under a
speculative attack.
– Suppose an economy is in bad shape, so
financial investors dump the currency, creating
a speculative attack. The CB responds by
raising the interest rate … which makes the
economy worse!
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Chapter 29: Exchange Rates and
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112
Should Exchange Rates Be Fixed or
Flexible?
 Monetary Policy
– Flexible exchange rates can strengthen the
impact of monetary policy.
– Fixed exchange rates prevent the use of
monetary policy to stabilize the economy.
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Should Exchange Rates Be Fixed or
Flexible?
 Trade and Economic Integration
– Fixed exchange rate proponents argue that
fixed rates promote international trade.
– Stable nominal exchange rates are good for
predicting the future, for exporting and
importing.
– The risk of a speculative attack may make the
country less attractive to investors and trade.
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Chapter 29: Exchange Rates and
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114
Examples
Should Exchange Rates Be Fixed or
Flexible?
 What were the causes and consequences of the
East Asian crisis of 1997-1998?
– Over 1997, East Asian currencies lost half of their value.
– To protect the pegs, central banks raised interest rates.
– Exports should have boomed, but many debts were
denominated in dollars. Because banks were badly run,
their assets quickly became worthless.
– The result was a sharp recession and the end of the
Asian Miracle.
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116
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117
Should Exchange Rates Be Fixed or
Flexible?
 How did policy mistakes contribute to the
Great Depression?
– Among many other mistakes, the US kept the
dollar pegged to gold for too long.
– This meant that exports were too expensive and
imports pretty cheap, further depressing
economic activity.
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118
Should Exchange Rates Be Fixed or
Flexible?
 Why have 11 European countries adopted a
common currency?
– Many Europeans believe that peace and prosperity can
only happen if there is political union in Europe. This
depends on economic union, which depends on trade.
– There is more trade if exchange rates are predictable …
or if the partners have the same currency.
– But that means that Ireland and Germany must have the
same monetary policy, which makes little sense.
 (Neither does it make sense for Florida and Louisiana to have
the same monetary policy, though).
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Chapter 29: Exchange Rates and
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119
Should Exchange Rates Be Fixed or
Flexible?
 Should the Fed defend the dollar? Should
the European Central Bank prop it up?
– I mentioned that the US Current Account deficit
suggests a massive dollar depreciation.
– If foreigners did not by US dollars, interest rates
would have to rise.
– This would mean a collapse of the housing
market. Should the Fed do anything about it?
– If the dollar collapses, European goods will be
more expensive, deepening the recession there.
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Chapter 29: Exchange Rates and
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120
What have we learned today?
 Nominal exchange rates:
– The rate at which two currencies can be traded
for each other.
 Real exchange rate
– The price of the average domestic good or
service relative to the price of the average
foreign good or service, when the prices are
expressed in terms of a common currency.
 Appreciation versus depreciation
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Chapter 29: Exchange Rates and
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121
What have we learned today?
 In the long run, the nominal exchange rate is
determined by Purchasing Power Parity.
 In the short run, the nominal exchange rate
is determined by supply and demand for
currency in the foreign exchange market.
– The fundamental exchange rate is the
equilibrium exchange rate in the market.
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Chapter 29: Exchange Rates and
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122
What have we learned today?
 Monetary policy is more effective in the
open economy because it affects
expenditure through the exchange rate in
addition to through the interest rate.
– Higher interest rates appreciate the currency,
which depresses net exports and output.
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Chapter 29: Exchange Rates and
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123
What have we learned today?
 A Central Bank may fix the value of the
currency in terms of another currency.
– If it does, it may have to raise or lower interest
rates to defend the exchange rate peg, losing
control over monetary policy.
– Fixed exchange rates lead to balance of
payments deficits or surpluses.
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Chapter 29: Exchange Rates and
the Open Economy
124